Post-Keynesian Ideas For A Crisis That Conventional Remedies Cannot Resolve

Tag Archives: james tobin

Thomas Palley on Robert Dimand’s book on James Tobin, as part of the Great Thinkers in Economics series edited by Tony Thirlwall:

James Tobin was a leading – perhaps the leading – American neo-Keynesian macroeconomist in the era of Keynesian dominance after World War II that extended through to the early 1970s. Along with growth theorist Robert Solow and micro and trade theorist Paul Samuelson, the three substantially shaped what became known as the neoclassical synthesis which fused neoclassical microeconomic theory, Keynesian macro theory, and neoclassical growth theory. The macroeconomic component of the neoclassical synthesis is termed neo-Keynesianism. All three received the Royal Bank of Sweden Prize in Economic Science in Memory of Alfred Nobel, with Tobin winning his prize in 1981. Tobin died in 2002, aged 84.

…

The good news is that Tobin’s macroeconomics remains profoundly relevant and can be revived theoretically, as suggested by the work of Godley and Lavoie (2007). Robert Dimand’s book further motivates the case for that revival.

Lars Syll has a nice post quoting James Tobin’s views on the real business cycle theory (and dynamic stochastic general equilibrium (DSGE) models. DSGE models are just RBC theory models with some modifications but still retaining the core).

There’s also another paper, An Old Keynesian Counterattacks by James Tobin written in 1992 and devoted heavily on attacking all this.

Tobin says:

The crucial issue of macroeconomic theory today is the same as it was sixty years ago when John Maynard Keynes revolted against what he called the “classical” orthodoxy of his day. It is a shame that there are still “schools” of economic doctrine, but perhaps controversies are inevitable when the issues involve policy, politics, and ideology and elude decisive controlled experiments. As a lifelong Keynesian, I am quite dismayed by the prevalence in my profession today, in a particularly virulent form, of the macroeconomic doctrines against which I as a student enlisted in the Keynesian revolution. Their high priests call themselves New Classicals and refer to their explanation of fluctuations in economic activity as Real Business Cycle Theory. I guess “Real” is intended to mean “not monetary” rather than “not false,” but maybe both.

I am going to discuss the issues of theory, Keynesian versus Classical, both then and now. Since the main purpose and preoccupation of macroeconomic theory is to guide fiscal and monetary policies, the theoretical differences imply important differences in policy. Moreover, prevailing doctrines seep gradually into the ways the world is viewed not only by economists but also by students, pundits, politicians, and the general public. It is in this sense but only in this sense that I shall be talking about current events.

The doctrinal differences stand out most clearly in opposing diagnoses of the fluctuations in output and employment to which democratic capitalist societies like our own are subject, and in what remedies, if any, are prescribed. Keynesian theory regards recessions as lapses from full-employment equilibrium, massive economy-wide market failures resulting from shortages of aggregate demand for goods and services and for the labor to produce them. Modern “real business cycle theory” interprets fluctuations a moving equilibrium, individually and socially rational responses to unavoidable exogenous shocks. The Keynesian logic leads its adherents to advocate active fiscal and monetary policies to restore and maintain full employment. From real business cycle models, and other theories in the New Classical spirit, the logical implication is that no policy interventions are necessary or desirable.

Should we describe the macro-economy by two regimes or one? The old Keynesian view favors two regimes. In one, the Keynesian regime, aggregate economic activity is constrained by demand but not by supply. If there were additional effective demands for goods and services, they could be and would be satisfied. “Demand creates its own supply.” The necessary inputs of labor, capital capacity, and other factors are available, ready to be employed at prices, wages, and rents that their productivity would earn. Only customers are missing.

The second regime, which Keynes called classical, is supply-constrained. Extra demand could not be satisfied at the economy’s existing capacity to produce. The needed workers or other inputs are not available at affordable wages and rents. The supply limits bring about prices and incomes that restrict aggregate demand to capacity output. Should capacity increase, those prices and incomes will automatically generate just enough additional purchasing power to buy the extra output. “Supply creates its own demand.”

Keynesians believe that the economy is sometimes in one regime, sometimes in the other. New Classicals model the economy as always supply-constrained and in supply-equals-demand equilibrium. In their real business cycle models, the shocks that move economic activity up and down are essentially supply shocks, changes in technology and productivity or in the bounty of nature or in the costs and supplies of imported products. Although external forces of those kinds, for example weather, harvests, natural catastrophes, have been the main sources of fluctuating fortunes for most of human history, and although events continually remind us that they still occur, Keynesians do not agree that they are the main source of fluctuations in business activity in modern capitalist societies.

and in the end concludes by asking:

Why do so many talented economic theorists believe and teach elegant fantasies so obviously refutable by plainly evident facts? Trying to answer that question would take us into a speculative excursion on the sociology of the economics profession, beyond the scope of this paper.

Stephen Kinsella is out with a new paper with co-authors Stephen Burgess, Oliver Burrows, Antoine Godin, and Stephen Millard published by the Bank of England.

From the paper:

Our paper makes two contributions to the literature. First, we develop, estimate, and calibrate the model itself from first principles as well as describing the stock-flow consistent database we construct to validate the model; as far as we know, we are the first to develop such a sophisticated SFC model of the UK economy in recent years.4 And second, we impose several scenarios on the model to test its usefulness as a medium-term scenario analysis tool. The approach we propose to use links decisions about real variables to credit creation in the financial sector and decisions about asset allocation among investors. It was developed in the 1980s and 1990s by James Tobin on the one hand, and Wynne Godley and co-authors on the other, and is known as the ‘stock-flow consistent’ (SFC) approach. The approach is best described in Godley and Lavoie (2012) and Caverzasi and Godin (2015) and underpins the models of Barwell and Burrows (2011), Greiff et al. (2011), and Caiani et al. (2014a,b). Dos Santos (2006) describes how SFC models incorporate detailed accounting constraints typically found in systems of national accounts. SFC models allow us to build a framework for the model where every flow comes from somewhere in the economy and goes somewhere, and sectoral savings/borrowings and capital gains/losses add or subtract from stocks of wealth/debt, following Copeland (1949). Accounting constraints allow us to identify relationships between sectoral transactions in the short and long run. The addition of accounting constraints is crucial, as one aspect of the economy we would like to model is the way it might react differently when policies such as fiscal consolidations are imposed slowly or quickly

4 Such models were popular in the past; for example Davis (1987a, 1987b) developed a rudimentary stock flow consistent model of the UK economy.

Recently, Noah Smith wrote an article for Bloomberg View, titled Economics Without Math Is Trendy, But It Doesn’t Add Up.

Smith’s attitude is the following:

Heterodox economics is vague and neoclassical economists are mathematical geniuses.

Heterodox authors somehow manage to sneak in some model of the economy.

How about something opposite? That stock flow consistent/coherent models come close to describing the real world and neoclassical models don’t even start in the right foot? The usage of mathematics in neoclassical economics looks silly to me to say the least. Heterodox authors on the other hand have made important breakthroughs with stock-flow consistent models. In these models, the description of how stocks and flows affect each other leading to macrodynamics describing the real world is obtained.

Neoclassical models (which the phrase I use for the “new consensus”) not only doesn’t have anything as mathematical as this but it fails in the first place to identify the correct tools to describe economic behaviour.

Morris Copeland writing in Social Accounting For Moneyflows in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949] said:

The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.

I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.

So it is not that neoclassical economists have great mathematical tools. It’s that by failing to incorporate the framework of flow of funds, they are showing their incompetence in mathematical reasoning.

A lot has been written on helicopter money recently. Most of them bad with a few exceptions such as one by JKH.

In my opinion, the main reason economists come up with stories such as “helicopter money” etc. is that it is difficult in standard economic theory to introduce money.

Few quotes from Mervyn King’s book The End of Alchemy: Money, Banking, and the Future of the Global Economy:

But my experience at the Bank also revealed the inadequacies of the ‘models’ – whether verbal descriptions or mathematical equations – used by economists to explain swings in total spending and production. In particular such models say nothing about the importance of money and banks and the panoply of financial markets that feature prominently in newspapers and on our television screens. Is there a fundamental weakness in the intellectual economic framework underpinning contemporary thinking? [p 7]

For over two centuries, economists have struggled to provide a rigorous theoretical basis for the role of money, and have largely failed. It is a striking fact that as as economics has become more and more sophisticated, it has had less and less to say about money… As the emininent Cambridge economist, and late Professor Frank Hahn, wrote: ‘the most serious challenge that the existence of money poses to the theorist is this: the best developed model of the economy cannot find room for it’.

Why is modern economics unable to explain why money exists? It is the result of a particular view of competitive markets. Adam Smith’s ‘invisible hand’ …

… Money has no place in an economy with the grand auction. [pp 78-80]

But the ex-Bank of England governor perhaps never worked with stock flow consistent models. The advantage of these models is that what money is and how it is created is central to the question of how economies work. The framework used in stock flow consistent models is not new exactly. What’s new in stock-flow consistent models is the behavioural analysis on top of the existing framework the system of national accounts and flow of funds. As Morris Copeland, who formulated the flow of funds accounts of the U.S. economy said:

The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.

I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.

– Morris Copeland, Social Accounting For Moneyflows in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949]

So what do we mean by helicopter money and it is really needed or useful? For that we need to go into a bit into some behavioural equations in stock-flow consistent models. One way is to use a somewhat simplified notation from Tobin’s nobel prize lectureMoney and Finance in the Macroeconomic Process. In Tobin’s analysis, the government’s fiscal deficit is financed by high-powered money and government bonds:

G – T = ΔH + ΔB

ΔH = γH·(G – T)

ΔB = γB·(G – T)

γH + γB = 1

0 ≤ γH, γB ≤ 1

So the deficit is financed by “high-powered money” (H) and government bonds (B) in proportion γH and γB

Now it is important to go into a bit of technicalities. Prior to 2008, central banks implemented monetary policy by a corridor system. After 2008, when the financial system needed to be rescued and later when central banks started the large scale asset purchase program (“QE”), central banks shifted to a floor system.

Although economics textbooks keep claiming that the central bank “controls the money supply”, in reality they are just setting interest rates.

In the corridor system, there are three important rates:

The deposit rate: The rate at which central banks pay interest on banks’ deposits (reserves) with them,

The target rate: The rate which the central bank is targeting, and is typically the rate at which banks borrow from each other, overnight, at the end of the day.

The lending rate: The rate at which the central bank will lend to banks overnight.

There are many complications but the above is for simplicity. Typically the target rate is mid-way between the lower (deposit rate) and the higher (lending rate).

In the floor system, the government and the central bank cannot set the overnight at the target rate if the central bank doesn’t supply as much reserves as demanded by banks. Else the interest rate will fall to the deposit rate or rise to the lending rate. In a system with a “reserve-requirement”, banks will need an amount of reserves deposited at the central bank equal to a fraction of deposits of non-banks at banks.

So,

H = ρ·M

where M is deposits of non-banks at banks and ρ is the reserve requirement. In stock-flow consistent models, M is endogenous and cannot be set by the central bank. Hence H is also endogenous.

In the floor system, the target rate is the rate at which the central bank pays interest on deposits. Hence the name “floor”. There are some additional complications for the Eurosystem, but let’s not go into that and work in this simplification.

In the floor system, the central bank and the government can decide the proportions in which deficit is financed between high powered money and government bonds. However since deposits are endogenous the relation between high powered money and deposits no longer holds.

In short,

In a corridor system, γH and γB are endogenous, M is endogenous and H = ρ·M. In a floor system, γH and γB can be made exogenous, M is endogenous and H ≠ ρ·M. M is not controlled by the central bank or the government in either cases and is determined by asset allocation decisions of the non-bank sector.

Of course, the government deficit G – T itself is endogenous and we should treat the government expenditure G and the tax-rates θ as exogenous not the deficit itself.

So we can give some meaning to “helicopter money”. It’s when the central bank is implementing monetary policy by a floor system and γH and γB are exogenous.

But this doesn’t end there. there are people such as Ben Bernanke who have even proposed that the central bank credit government’s account with some amount and let it spend. So this introduces a new variable and let’s call it Gcb.

So we have a corridor system with variables G and θ versus a floor system with variablesG’, G’cb, θ, γ’H and γ’B

The question then is how is the latter more superior. Surely the output or GDP of an economy is different in the two cases. However people constantly arguing the case for “helicopter money” are in the illusion that the latter case is somewhat superior. Why for example isn’t the vanilla case of a corridor system with higher government expenditure worse than “helicopter money”.

Also it effectively reduces to a fiscal expansion combined with a large scale asset purchase program of the central bank (“QE”). I described QE’s effect here. Roughly it works by a wealth effect on output with some effect on investment via asset allocation.

To summarize, the effect on output by these crazy ways can be achieved by a higher fiscal expansion. There’s hardly a need to bring in helicopters. Some defenders say that it is faster but that just sounds like an excuse to not educate policymakers.

I believe that the basic problem today is not the exchange rate regime, whether fixed or floating. Debate on the regime evades and obscures the essential problem … Clearly flexible rates have not been the panacea which their more extravagant advocates had hoped … I still think that floating rates are an improvement on the Bretton Woods system. I do contend that the major problems we are now experiencing will continue unless something else is done too.

– James Tobin, A Proposal For Monetary Reform, 1978

Frances Coppola has written a post saying that floating exchange rates are not the panacea. Although I agree with her point, there are however a few points in her article which has some issues. She says that money stock is exogenous in gold standard.

Under a strict gold standard, the quantity of money circulating in the economy is effectively set externally. The domestic money supply can only grow through foreign earnings, which bring gold into the country.

… This is evident from the quantity theory of money equation MV = PQ, which is fundamentally flawed in a fiat currency fractional reserve system but works admirably under a strict gold standard or equivalent.

Frances is critiquing Neochartalists there but ends up accepting their notion that macroeconomics is something different when a nation’s currency is not floating and there’s an exogenous stock of money in fixed exchange rate regimes. There is absolutely no proof that it is so. Money stock can grow if there’s higher economic activity due to rise in private expenditure relative to income or via fiscal policy. But why this obsession with Monetarism? It doesn’t work anywhere: whether the exchange rate is fixed or floating. All arguments made in Post Keynesian economics carry through to the gold standard. Indeed Robert Mundell himself realized this in 1961 [1].

Here’s a quote from the book Monetary Economics by Wynne Godley and Marc Lavoie, page 197, footnote 11:

It must be pointed out that Mundell (1961), whose other works are often invoked to justify the elevance of the rules of the game in textbooks and the IS/LM/BP model, was himself aware that the automaticity of the rules of the game relied on a particular behaviour of the central bank. Indeed he lamented the fact that modern central banks were following the banking principle instead of the bullionist principle, and hence adjusting ‘the domestic supply of notes to accord with the needs of trade’ (1961: 153), which is another way to say that the money supply was endogenous and that central banks were concerned with maintaining the targeted interest rates. This was in 1961!

Bretton Woods was the emperor’s new clothes and floating exchange rates are the emperor’s new new clothes. The important question is whether floating exchange rates offer any market mechanism to resolve balance of payments imbalances and the answer is that it doesn’t. In gold standard, current account deficits can be financed by official sale of gold in international markets and residents borrowing from abroad. In floating exchange rate regimes, it is financed by borrowing from abroad. Hardly much difference. So the main adjustment is left to movement of the exchange rate. One needs to suspend all doubt and believe in the invisible hand to think the movement of exchange rates can do the trick. The reason it is the emperor’s new new clothes is that the promises never worked. And similar promises were made by economists that there’s a market mechanism to resolve balance of payments imbalances in fixed exchange rate regimes.

To summarize, my argument is that the only point to debate is whether floating the exchange rate resolves imbalances as compared to fixed exchange rates, not about the endogeneity of money. Although there is a role because of the movement of the exchange rate, floating exchanges is not a panacea. Although I am not on the side of the Neochartalists in the debate, I thought I’d point this out: do not fall into the pitfall of your opponent.

There is always some debate by people on how continuous time is better modelling. A James Tobin quote from his Nobel Lecture comes to mind.

Macroeconomic Modeling Strategy: Continuous or Discrete Time

The issues just discussed are related to the modeling of time. The equations introduced above count time in discrete periods of equal finite length. Within any period, each variable assumes one and only one value. In particular, clearing of asset markets determines one set of asset prices per period. From one period to the next asset stocks jump by finite amounts. Therefore the demands and supplies for these jumps affect asset prices and other variables within the period, the more so the greater the length of the period. They will also, of course, influence the solutions in subsequent periods.

The same modeling strategy can be used with continuous time. The specific saving functions, as well as the total saving function, then tell the rate at which savers want to be increasing their stocks of particular assets and of total wealth. They will reflect both the continuous execution of long run saving and portfolio plans and the speeds of adjustment of stocks to deviations from these plans that arise because of surprises, news, and altered circumstances or preferences.

Either representation of time in economic dynamics is an unrealistic abstraction. We know by common observation that some variables, notably prices in organized markets, move virtually continuously. Others remain fixed for periods of varying length. Some decisions by economic agents are reconsidered daily or hourly, while others are reviewed at intervals of a year or longer except when extraordinary events compel revisions. It would be desirable in principle to allow for differences among variables in frequencies of change and even to make those frequencies endogenous. But at present models of such realism seem beyond the power of our analytic tools. Moreover, many statistical data are available only for arbitrary finite periods.

Representation of economies as systems of simultaneous equations always strains credibility. But it takes extraordinary suspension of disbelief to imagine that the economy solves and re-solves such systems every microsecond. Even with modern computers the task of the Walrasian Auctioneer, and of the market participants who provide demand and supply schedules, would be impossible. Economic interdependence is the feature of economic life and we as professional economists seek to understand and explain. Simultaneous equations systems are a convenient representation of interdependence, but it is more persuasive to think of the economic processes that solve them as taking time than as working instantaneously.

In any event, a model of short-run determination of macroeconomic activity must be regarded as referring to a slice of time, whether thick or paper thin, and as embedded in a dynamic process in which flows alter stocks, which in turn condition subsequent flows.

The accounting identities equating aggregate expenditures to production and of both to incomes at market prices are inescapable, no matter which variety of Keynesian or classical economics you espouse. I tell students that respect for identities is the first piece of wisdom that distinguishes economists from others who expiate on economics. The second? … Identities say nothing about causation.

This is a continuation of my post Stock-Flow Inconsistent? which was a reply to Jason Smith’s blog post More like stock-flow inconsistent on his blog Information Transfer Economics. If you had checked my post before around noon UTC yesterday, you might want to check the updated version.

Jason Smith also has updated his post and proposes a new equation:

ΔH = Γ·(G – T)

(incorrect equation)

Now, that’s quite wrong because it violates rules of accounting.

Morever, Jason Smith insists that it is a behavioral equation.

A lot of clarity can be achieved if one uses subscripts, so that things are clearer.

So we have two equations:

ΔH = G – T

dH/dt = G – T

Although these two are related, they are not exactly the same: the former is in a difference equation form and the latter in the differential equation form. The G in the former has no time dimensions and the G in the latter has time dimension equal to –1. The G in the former is total expenditure in a period, the G in the latter is a rate.

Since stock-flow consistent models are written typically in difference equations, rather than differential equations, let us avoid subscripts for difference equations for the former and use it for latter.

So it is better to write the equations as:

ΔH = G – T

dHcontinuous/dt = Gcontinuous – Tcontinuous

Each time step in the formalism of difference equations is Δt and hence

Eric’s post is arguing with the Neochartalists but my post here has nothing to do with Neochartalism. I always find it amusing when people go “money is not the liability of the state, even though it’s technically a liability” and so on. I am going to take a different track here and make an argument like James Tobin’s brilliant 1963 paper Commerical Banks As Creators Of “Money” . I explained Tobin’s brilliant analysis in a post James Tobin, Banking And The Widow’s Cruse.

For this, I will go to a scenario in an open economy:

£ is the local currency and $ is the foreign currency.

Suppose foreigners hold £1bn in currency notes among other claims on residents. Of course in real life nobody holds £1bn in cash notes but I can always make my case more realistic.

Suppose the exchange rate £/$ is falling and the foreign exchange market is nervous and runaway expectations are building up on the exchange rate.

This forces the “£-central bank” to intervene.

The central bank has less foreign reserves, i.e., $s and hence asks the government treasury to issue $-denominated debt equivalent £1bn. This is done to obtain proceeds to make a sale of $s in the fx markets, with the hope that it reverses the direction of expectations.

The central bank sells $s worth £1bn in the foreign exchange market.

Foreigners who held £1bn in currency notes are the counterparties.

So liabilities have been dollarized.

Now in this story, the net asset position of the £-nation hasn’t changed. The net international investment position is the same. Only the composition of liabilities. However people who claim that “currency is not really a liability” will agree that the government has a liability in $s. In their way of counting, there is an additional liability (after netting). But that doesn’t make sense. I just walked you through transactions of equal monetary exchanges. If you think

money is not a liability of the state.

do you not see a self-inconsistency here?

In other words, the potential for liability dollarization makes accounting items such as currency notes, reserve balances at the central bank etc. as a liability in a true sense.

The accounting identities equating aggregate expenditures to production and of both to incomes at market prices are inescapable, no matter which variety of Keynesian or classical economics you espouse. I tell students that respect for identities is the first piece of wisdom that distinguishes economists from others who expiate on economics. The second? … Identities say nothing about causation.

This is such a nice quote by James Tobin. Almost all economists, orthodox or heterodox would agree with it I believe.

In practice, however, economists confuse identities for behaviour and causation no end. They even confuse identities themselves. But it now seems that some think that usage of national accounting identities produces erroneous conclusions.

In a series of posts, (here and few posts before), David Glasner, the author of the blog Uneasy Money — Commentary on monetary policy in the spirit of R. G. Hawtrey, seems to be suggesting that letting identities go is the way forward for macroeconomic modeling.

Glasner says:

There are two reasons why defining savings and investment to be identically equal in all states of the world is not useful in a macroeconomic theory of income. First, if we define savings and investment (or income and expenditure) to be identically equal, we can’t solve, either algebraically or graphically, the system of equations describing the model for a unique equilibrium.

[boldening and emphasis added]

So it seems that using accounting identities in your model would lead to inconsistencies. I and a few other commenters have tried to convince Glasner of his errors in series of posts.

Some people seem to think that identities do not tell anything. The truth is not so straightforward. Identities constrain outcomes. Any macroeconomic model which does not use identities as constraints may produce non-possible states of the world.

Brad deLong confronted Glasner on Twitter with this point:

.@david_glasner well, at least they are better than theories of national income that violate accounting identities… @Noahpinion